European Pilot Regime: Experimental regulations to foster innovation

A first in Europe to reconcile experimentation and regulation

At the beginning of 2023, Europe should officially launch a major experiment to test the blockchain and distributed ledger technology (DLT) on the financial markets, a technology that was born with the now famous and sometimes controversial Bitcoin. In addition to the very high volatility of its price, Bitcoin has the extreme singularity of not having an identifiable issuer and yet being able to validate the exchanges and transfers of ownership of this new digital asset without an intermediary.

This experiment, called the Pilot Regime, should last at least 3 years (renewable once) and will allow the European authorities in charge of market regulations to better understand the supposed benefits of this new technology, but also and more importantly the potential challenges to existing regulations and infrastructures. As investor protection and market integrity have so far been based on the regulating of issuers and intermediaries, the potential absence of both is a huge challenge for market authorities.

However, we should keep in mind that the Pilot Regime is not intended to deal with Bitcoin and other cryptocurrencies that are covered by the MiCA¹ regulation, but only financial instruments as defined by MiFID² regulations and therefore supposed to have an issuer. That means it will be necessary to first decide on the role and responsibility of the issuer when it chooses to deposit its securities in a blockchain. It is also essential to mention that the Pilot Regime is essentially focused on listed financial securities, as only issuers of listed securities are legally obliged to deposit their securities with a CSD³ , while issuers of unlisted securities remain fully responsible for the record-keeping of their securities and are therefore free to choose the underlying technology.

Distributed ledger VS centralised ledger: A total paradigm shift

The first level of the Pilot Regime text was mainly aimed at reducing the risks of the experiment by limiting the volume of tokenised issues and by requesting from participants the implementation of an “exit strategy” to be able to terminate the experiment in case of failure. The other key feature of the Pilot Regime is the introduction of the concept of DLT SS (Settlement System) and not DLT CSD. This is indeed important because if the CSD is also an SS operator, it also ensures a notary function by centralising the issuing account of listed securities. By recognising that these two CSD functions can now be dissociated in a Distributed Ledger, the legislator is implicitly challenging the systematic transfer of the record keeping of listed securities to a trusted third party such as a market infrastructure.

While the Pilot Regime seems to question the relevance of some intermediation constraints imposed by current regulations, it does not mention other types of intermediation such as those freely chosen by market participants. In its recent guide on DLT, the French Association of Securities Professionals (AFTI) also addressed the subject of disintermediation in post-trade activities. According to its analysis, it would be the intermediaries imposed by current regulations that would mainly be impacted by the new technology, i.e. the CSD but also the custodians. These imposed intermediaries have two essential roles to play in securing the transfer of ownership of listed securities: to “centralise” the record keeping (centralised ledger) for issuers or investors; and to operate a settlement system, the first role appearing until now to be a sine qua non condition for the exercise of the second, both of which then allow these intermediaries to offer a wide range of value-added services (tax, reporting, corporate transactions, collateral, etc.)

According to the guide, the transition from a “centralised ledger” approach to a “distributed ledger” approach should make it possible to better secure record keeping and thus enable the issuer to retain responsibility for the record keeping of listed securities in the same way as for unlisted securities. In theory, it would then be possible to have a single legal regime for all financial securities in a Distributed Ledger, whether they are listed or unlisted.

French assets to compete for pole position in the Pilot Regime

This single regime appears to be very close to the French model of “essentiellement nominatif” securities, which already allows for a single form of securities, the so-called Registered form, for listed and unlisted securities. In this model, it is the issuer of the securities and not the CSD that is responsible for record keeping and custody of registered securities. For these securities, the CSD must only ensure the role of Settlement System (SS) operator, similar to what the Pilot Regime has planned with its DLT SS. If this regime for essentially registered securities has not been a huge success in France so far, it is mainly because of current technology limitations. The use of the Distributed Ledger could therefore completely change the situation and eventually make the current distinction between bearer and registered securities obsolete. Indeed, registered securities deposited in a Distributed Ledger could combine the current advantages of registered securities (knowledge of investors by the issuer) and bearer securities (ease of settlement) without any additional cost for participants with even probable cost reductions. CSDs and custodians would continue to perform their current role for these listed registered securities, i.e. operator of an SS for the CSD and administration service (“nominatif administré”) for the custodians, while of course continuing to offer all the value-added services mentioned above.

In the end, this European Pilot Regime appears to be a wonderful opportunity to rethink, simplify and optimise the management of market operations, and in particular the entire post-trade segment. It also appears that the French market is particularly well placed to make the most of this experiment. Firstly, because its current model seems to be able to converge fairly easily with that of the Pilot Regime, but also because it took an interest in the subject very early on, which enabled certain French players to acquire real expertise that they should be able to use during the Pilot Regime experiments.

¹ Markets in Crypto assets regulation
² Markets in Financial Instruments Directive
³ Central Securities Depository